July 14, 2022
In this brief article, I intend to help prospective investors become aware of how corporations actually operate and how this affects their investment in a company. There is a general misconception that shareholders rule a company. They are often viewed as the definitive authority with ultimate voting power. In reality, it is the board of directors, a small group of selected individuals that run the show. As an investor you should be aware of this flawed misunderstanding and the two main reasons for this balance of power.
The first is the law. Corporate law favors directors and authorizes them to administer the company in very broad terms. We will get to this in detail. The second is the nature and composition of shareholders. Except for closely held, family-owned corporations, most large companies are composed of hundreds or even thousands of shareholders who posess diverse interests and objectives.
Shareholder composition
As a shareholder of a large, publicly traded company, there is little you can do to promote your opinions but at least you are aware of the limitations when considering to invest. Shareholders are detached from the operations for the company, they get to meet once a year. Reports are circulated in a need-to-know basis. If you want to know where the company is going, it is advisable to seek out documentation prepared by, guess who, the directors of the board.
However, if you are an investor and thinking of buying shares of a small or closed corporation and plan to have your opinion counted, you need to be aware of the general rules and the content of existing or intended bylaws that will govern the entity and your participation.
Board rights under the law regulations
While shareholders own the company as shares owners, the law assigns the decision to the board of directors, who in turn delegate powers to officers that run the day-to-day operation. Once a company is large enough, it is not feasible to have shareholders run the show. That is where the law steps in.
The same applies to a limited liability company. Members can operate a company but as new members come in, it becomes necessary to have the company be administered by managers and not the members themselves.
The Governance Model: A Civic Analogy
A useful analogy is the U.S. system of government. Shareholders are like voters: they do not run the organization directly but exercise authority through elections. They elect the board of directors, which functions like Congress—setting policy, establishing the framework within which the organization operates, and overseeing management. The officers, in turn, are like the executive branch: they administer the company’s day-to-day operations and implement the policies established by the board. In this structure, ultimate authority rests with the shareholders, but governance and supervision are carried out by the board, while execution is delegated to management.
Boards have power under the law to appoint, compensate, and remove executive officers, as well as to exercise veto and decision-making authority over their actions. This authority is tied to the board’s fiduciary duty to act in the best interests of the corporation, which explains why the law supports board independence and some detachment from direct shareholder control. In practice, however, it is not uncommon for boards to pursue their own interests at the expense of the owners. Whether a board is effective, controlled, or manipulated by the chief executive officer is a separate issue, but it happens and often reflects weak board governance and limited mechanisms for shareholder accountability.
Shareholder Rights Under Corporate Law and Regulations
Shareholders generally exercise three principal categories of rights: decision rights, appointment rights, and removal rights. These rights are intended to provide oversight and help limit potential abuses by directors and executive officers. The scope and exercise of these rights depend on the jurisdiction where the corporation is organized and the provisions contained in the company’s governing documents.
Shareholder Decision Rights
Decision rights refer to matters that corporate law or the company’s bylaws reserve for shareholder approval. Depending on the jurisdiction and the corporation’s internal rules, shareholders may have voting rights over issues such as mergers, amendments to governing documents, the sale of substantial assets, or other extraordinary corporate actions.
Appointment and Removal of Directors
Appointment and removal rights generally relate to members of the board of directors. Shareholders typically elect directors and, under certain circumstances, may also vote to remove them if they believe the directors are not acting properly or in the best interests of the corporation. The procedures and requirements applicable to these rights vary depending on state law and the corporation’s bylaws.
Limits Imposed by Corporate Law and Bylaws
Corporate law is primarily regulated at the state level, which means shareholder rights vary by jurisdiction. In Puerto Rico, corporate governance matters are governed principally by the Puerto Rico General Corporations Law. In addition, a corporation’s bylaws operate as internal rules governing the interaction among shareholders, directors, and officers. Bylaws may establish procedures and limitations regarding meetings, notice requirements, voting rights, and the matters shareholders may formally consider.
The future of shareholders
There has been an ongoing debate for decades as to how to improve the relationship between shareholders, directors and the long-term objectives of a company. Many obstacles are on the way for numerous factors including the broad spectrum of investor composition that share ownership of a company These include individual, day-traders, institutional investors, pension and hedge funds, and others. Each has its own objectives and agenda, that may conflict with other shareholders and with the long-term viability of the company. Some are looking for immediate returns. Other seek long-term growth. Each objective requires different management approaches.
I do not seek to present a comprehensive exposition of how shareholders and board members interact. The point of this article is to have investors of small, medium, or large corporations be aware of what their roles will be as they acquire ownership participation.
Because structuring your internal regulations is vital for long-term success, Fleming Law Offices provides specialized guidance on corporate governance in Puerto Rico.